To Eliminate All the Tax Issues Related to Electing Revenue Ruling 70-604 and Taxable Membership Income, Why Don’t You Suggest That Boards Contribute the Excess Operating Revenue to Reserves Each Year?
Answer- Here are five reasons for not transferring excess operating monies to reserves (replacement fund) at the end of each year. Some of the reasons are interrelated to each other.
- In order to exclude the funds from taxation as a capital contribution to reserves, the IRS requires a purpose for the funds and notification to the membership. It cannot just arbitrarily be done. This generally involves a new reserve study to document the need for the additional funds and a distribution of the decision to the members.
- Sometimes replacement fund items do not need any additional funding. The transfer would only work for tax purposes if the money was put aside for capital reserve components and they may be fully funded.
- The amount to transfer to reserves is calculated at the time of the audit which is completed several weeks/months after the end of the year. We CPAs go through a convoluted computation to determine excess membership income for tax purposes (which does not agree with net income on the financials statements). We add back in noncapital reserve allocations and subtract out noncapital reserve expenses. This calculation may result in more income than what the Association has in operating cash, because some of reserve cash is actually noncapital in nature.
- Reserve monies are highly restricted by industry standards and, in some instances by law. Thus, once the money was transferred to reserves and if found to be needed in operating, there would be borrowing issues.
- It is good fiscal practice to keep a “cushion” in the operating fund for contingencies. We recommend 1-3 months of operating expenses and CAI National recommends a minimum of ½ of a month of operating expenses with 2 months being a good practice.
Gayle Cagianut, CPA
